Beware the next wave of the Treasury market selloff.
While investors focus on soaring yields on U.S. bills and the 10-year note, global markets may be at the mercy of a fresh threat: a rising term premium, or the extra compensation to hold longer-maturity debt over short-term securities.
Strengthening price pressures as the economic upswing intensifies in concert with diminishing monetary stimulus look poised to awaken duration risk from its post-crisis slumber, according to strategists and investors.
Add the prospect of diminished foreign appetite for U.S. debt, and upward pressure looks set to intensify on the Treasury metric, which influences valuations for risk assets around the world from stocks to emerging-market debt.
“Term premia are likely to rise even if the Fed has a tendency to flatten the curve by raising rates potentially more than the market has been currently expecting,” said John Stopford, the head of multi-asset income at Investec Asset Management, which oversees $141 billion, on Bloomberg TV this week. “Volatility is something we haven’t yet seen much of yet but I expect to see more in Treasuries.”
One estimate of the gauge by the Federal Reserve Bank of New York remains in negative territory after rising to May 2017 levels earlier this month amid the global rout before easing. To bond bears, that suggests the worst may be yet to come.
Market distortions wrought by monetary stimulus are receding while U.S. growth gathers pace, setting the stage for higher longer-dated premiums as early as the second half of the year, according to Goldman Sachs Group Inc.
“We find that U.S. term premium should increase as the economy progressively overheats,” strategists led by Francesco Garzarelli wrote in a recent note.
While Wall Street has long warned that this estimated metric is set to rise from depressed levels, its current gap with the advancing economic cycle looks unsustainable, according to Goldman Sachs. “The gap the term premium needs to fill to converge to historical norms is getting bigger.”
That echoes European Central Bank Executive Board member Benoit Coeure, who last month warned of a “correction” in risk valuations once markets price-in higher inflation volatility that sends the term premium higher.
The Bank for International Settlements has long warned that low term premiums in advanced economies have pushed foreign investors into emerging markets, strengthening linkages between bond markets around the world.
The revival of long-dormant Treasury risk versus risk appetite
While estimating the level and drivers of the metric is notoriously complex -- with global savings and demographic forces likely to exert downward pressure anew -- bearish prognostications are piling up.
Take Michael Howell, founder of research firm CrossBorder Capital Ltd., a two-decade veteran of fixed income.
He projects a second leg in the Treasury selloff, spurred by a rising duration premium that sends the 10-year to 3.5 percent this year and steepens the curve -- departing from Wall Street consensus that the gap between short- and long-dated benchmarks will continue to flatten.
The biggest driver? Diminishing demand for safe assets. Seventy percent of the variation in the U.S. 10-year volatility-adjusted term premium since 2000 alone can be explained by capital flows, he estimates. And net capital flows are depressing the metric by around 50 basis points.
“U.S. fixed income markets may, therefore, have already adjusted to the likely future policy interest rate regime, but the next coming adjustment phase will involve rising term premia,” he wrote in a report this week. “Returning flight capital, potentially more volatility and the likelihood of massive funding demands will surely push term premia back towards their ‘normal’ levels.”
To be sure, even the most-ardent bond bear projects the metric will return to levels far below its long-term average. And it’s just one of a slew of challenges markets are navigating from supply and interest-rate increases to price pressures. Meanwhile, economic expansion and productivity would feed the market rally even if compensation for duration rises.
But this Treasury test for risk appetite may have only just begun.
“The elephant in the room is what such normalization implies for global asset valuation, and whether we now have a so-called ‘everything bubble’ which is at risk of being deflated by the exit process of Fed, ECB, BoJ and others,” Martin Enlund, an analyst at Nordea Bank AB, wrote in a recent note.
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